Competition for Fannie Mae and Freddie Mac? Could the Colossal Mortgage GSEs Begin Taking Even Greater Risks Than They Already Are?

Frame, W. Scott, White, Lawrence J., Regulation

THE FEDERAL NATIONAL MORTGAGE Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are the two dominant entities in the finance of residential mortgages. Their rapid growth in the 1990s began attracting political attention earlier this decade. An increase in Fannie Mae's exposure to interest rate risk in 2002, followed by a widely reported accounting scandal at Freddie Mac in 2003, sharpened political concerns about the strength of the regulatory regime that surrounds the two entities.

Less widely recognized are two emerging and potentially powerful sources of new competition for Fannie Mae and Freddie Mac: an expanded mortgage finance program by the Federal Home Loan Bank System and new bank risk-based capital standards that are likely to be implemented in 2006. More competition should generally be welcomed. But this heightened competition could create incentives for Fannie Mae and Freddie Mac to take greater risks, with potentially unfavorable consequences for U.S. taxpayers. As a result, unless the two firms were to be privatized quickly (which is highly unlikely), enhanced regulatory scrutiny will be in order.

BACKGROUND

Though both Fannie Mae and Freddie Mac are publicly traded companies, they are the creations of the federal government, having been established by specific acts of Congress. Consequently, they (along with the Federal Home Loan Bank System and a few other special entities) are often described as "government-sponsored enterprises" (GSEs).

The specific activities of Fannie Mae and Freddie Mac are virtually identical and consist of two components:

* They issue mortgage-backed securities that carry corporate guarantees with respect to the credit (default) risk on the underlying residential mortgages.

* They invest in large portfolios of residential mortgage-related assets (whole mortgages and their own mortgage-backed securities) that are funded almost entirely (about 96-97 percent) with debt raised in the securities markets.

Table 1 shows the year-end amounts of Fannie Mae and Freddie Mac's mortgage-backed securities outstanding and their mortgage-related assets held in portfolio for 2003 and selected earlier years of the past two decades. As can be seen, their growth has been breathtaking. Ranked by assets on their balance sheets, Fannie Mae and Freddie Mac currently are among the five largest firms in the United States.

PRIVILEGES AND LIMITS Fannie Mae and Freddie Mac enjoy a number of special privileges as part of their federal charters: They are exempt from state and local income taxes; they are exempt from Securities and Exchange Commission (SEC) securities registration requirements and attendant fees; they each have potential lines of credit with the U.S. Treasury of up to $2.25 billion; their securities can be purchased by the Federal Reserve for open-market operations; they can use the Fed as their fiscal agent; and their securities can be purchased in unlimited quantities by banks and thrift institutions. As an indicator of the "federalness" of their charters, the president can appoint five of their 18 board members. Also, as a practical recognition of their specialness, the financial pages of daily newspapers usually list prices and yields of Fannie Mae and Freddie Mac's debt issuances (along with those of other GSEs) in a special box labeled "government agency issues" that is usually located immediately adjacent to the box showing the prices and yields of Treasury debt.

Some of Fannie Mae and Freddie Mac's special privileges (e.g., tax exemptions, fee exemptions) have a direct effect in reducing their operating costs. However, the largest source of savings arises because their charter attributes (plus some important history) strongly suggest to the financial markets that, in the event that either company experienced serious financial difficulties, the federal government would likely not allow their creditors to suffer financial losses. …

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